In this section we are going to look at how money is created, a power that over
the years people have only dreamed of possessing. While it may not be possible to
turn eggs into gold, it is certainly possible to create money. To understand the
process, the key players and concepts must be identified. First, there is the
measurement of money - what it is being created. The process is described in Diagram
1 below. Let's start at the end - with the supply of money. When people talk
about the money supply they will be talking about M1 - the value of coins and currency
held by the public outside of the banks (cash in our pockets) plus the value of our
checking account balances (demand deposits). [They may also be talking about
M2 which is a broader measure of money].

The process begins with the Fed who controls the amount of currency that gets
into the system. Actually it is the mint, an arm of the US Treasury Department that prints the money and then sends it to the Federal Reserve, but that is a finer
point we need not concern ourselves with at this time. It is the Fed who puts
the money into the system and the currency it supplies is called high-powered money. This is what the Fed directly
controls, but it is not the money supply. The high-powered money ends up in two
places - the vaults of the banks as reserves, or the pockets of people and businesses as
cash. Given the nature of the banking system, it is the banks that actually create
money. The cash held by the banks is called reserves and these reserves are the base
for banks' expansion of checking accounts. If you add the currency held by the public with
the deposit (checking) accounts created by the banks, you have the money
supply. To understand the supply of money, therefore, it will be
necessary to look more carefully at two institutions - the Fed and the banks.

Diagram 1Money Supply Process

When examining the money supply process it is important to realize the US
monetary system is in the midst of a rather lengthy evolutionary process. The US has come
a long way from the use of tobacco as money in colonial times and the circulation of
individual bank notes where there would be $1 note issued by First Federal National Bank
circulating with $1 bank notes issued by American National Bank. The problem for
consumers was the value of a $1 note issued by First Federal National Bank would not
be worth the same as $1 issued by American National Bank. Along the way we have also
struggled to find ways to eliminate the reoccurring banking crises that plagued the US -
the most notable being the closing of banks during the Great Depression.

One of the major sources of difficulty in the financial system can be traced to
the fact it is a fractional reserve system. The logic is quite simple - what I refer
to as the Robin Hood effect. Since money has no intrinsic value, there are gains to be
made from any reduction in the resources society devotes to the production and
distribution of money. In the beginning - or at least where we picked up the story, gold
was being transported through Sherwood Forest to finance transactions. This required
people to mine the gold, refine it, and guard it during its transfer. It offered a
wonderful opportunity for Robin Hood and his merry band of "liberators."

Eventually, however, someone realized the transaction could take place if
the sheriff deposited the gold in a safe place - a goldsmith's vault being the most likely
place - and receive a receipt from the goldsmith who promised to provide the holder of the
receipt with gold when it was returned. These receipts could then circulate as money. It
did not take long for the goldsmith to realize there was an opportunity for gain. At
the end of each day the goldsmith would find all of the notes had not been returned
so there was some gold sitting in the vaults - a simple statistical likelihood.

The temptation was too great and the goldsmith decided to get into the lending
business. Knowing there was extra gold in the vaults at the end of the day, the
goldsmith took a chance and distributed new notes promising to repay the note's holder
gold. So now we had a goldsmith with 100 ounces of gold while there were people with notes
promising to pay 200 ounces of gold.

The system that has just been outlined is called a fractional reserve systemand it is a key piece in the
money supply process. The system can be represented by Diagram 2 below. We
start on the left-side with the Fed's supply of high-powered
money which is held either as currency
by the public or reserves by the banks. The banks
are told that if they create demand deposits they will be required to hold in their
vault some cash as required reserves. These banks may also hold some excess reserves, cash they do not use to create demand deposits - just some extra cash "hanging
around" in the vault. The banks' ability to create money from the cash is seen
in the positive slope of the demand deposit line - a small amount of reserves becomes a
bigger amount of demand deposits. Excess reserves, meanwhile, do not appear in the
money supply so any increase in excess reserves will lower the supply of money.

Diagram 2Money Multiplier

Three important features of the system are:

Bank profitability:banks are in business for profit
and we should expect that their decisions are guided by the profit motive and not the
interests of the nation

Bank discretion over money supply: bankers' decisions affect money supply.
If bankers decide to increase the value of demand deposits then the money supply will
increase, while if they increase their holdings of excess reserves the money supply will
decrease.

Exposure to runs: potential conflict between profits and safety. The banks
will be tempted to expand the demand deposits which will mean that if all depositors
wanted their cash, the banks could not honor the claims. This is what you saw in the
movie It's a Great Life with Jimmy Stewart struggling to pay all of the
depositors.

Given the importance of money and the potential conflict between profits and
safety, the government has become involved in the regulation of the banking system.
The goal of the government is to avoid the banking panics that have plagued this country
since the earliest days, the types of panics that contributed to the depth and duration of
the Great Depression. The four important aspects of bank regulation are:

Deposit insurance:deposits are insured which lowers
the fears of customers who will not be as likely to run to the bank to withdraw their
funds when they hear a "rumor" about the bank.

Bank examinations:banks' books are periodically
reviewed so that we are less likely to have banks that adopting risky strategies that will
result in bank closures.

Limitations on assets: banks cannot hold some assets that are deemed risky.
This is what happened in Japan in the 1990s when the value of real estate plunged
and it is what happened in the great depression in the US when the value of banks' holding
of corporate stocks dropped sharply. As a result commercial banks were restricted from
holding corporate stock as an asset.

Required reserves:banks required to keep cash on
hand. This would limit the amount of money that could be created from a given amount of
reserves and it would thus decrease the chance that the banks would have inadequate
reserves to meet their obligations.

The Fed

The Federal Reserve System (Fed) is the central bank
of the United States - the equivalent of the Bank of Sweden, Bank
of England, and the Bank of France which were established in 1656, 1694, and
1800. The Fed represents the United States' third try at establishing a
central bank. The first came in 1790 and the second in 1816 - each lasting
twenty years. Between 1836 and the establishment of the Federal Reserve in 1914,
the US was without a central bank.

In fact there are twelve Federal Reserve Banks - one
for each of the twelve Federal Reserve Districts. The reason for the twelve
banks is the long-standing aversion Americans had for the concentration of
financial power. By dividing the country into twelve smaller regions, the
Fed would be more accountable to the interests of the people in a particular
region. If you were in Rhode Island, you were more likely to be able to
influence policy by lobbying the regional Federal Reserve bank than you could a
national system located in Washington, D.C. Rhode Island is in the
first district which includes almost all of New England and has its bank in
Boston. The structure of the system is described in Diagram 3 below. The
President of the United States, with Senate approval, appoints the seven members
of the Board of Governors. Each Federal Reserve Bank has a president who is
elected by the banks that are members of the system in that region.

The seven members of the Board of Governors and five
bank presidents - one being the president of the New York City bank and the
other four being rotating presidents of the remaining eleven banks - form
the Federal Open Market Committee (FOMC). This is the group most
responsible for setting monetary policy in the United States. It is the
meetings of this group that grab the headlines as the financial press attempts
to anticipate the Fed's moves. In 1998, for example, the business press
was filled with stories centered on the Fed and its decisions regarding interest
rates as it tried to help guide the economy through the Asian crisis by lowering
interest rates. Would the Fed lower rates to protect the economy from the
Asian crisis? Would the Fed raise interest rates to eliminate any
inflationary pressure in the economy? These questions were all directed at
the decisions of the FOMC.

Diagram 3
Structure of the Federal Reserve

In this section we will be examining the tools the
Fed can use to achieve its policy goals. Here we will learn what the Fed could
do if it did want to increase interest rates or increase the money supply.
Before examining the tools, however, we need to look at what it is the tools are
used to accomplish. Below you have the Fed's function in its own words.

Today, the Federal Reserve's duties fall into four general areas:

1. Conducting the nation's monetary policy by
influencing the money and credit conditions in the economy in pursuit of full
employment and stable prices

2. Supervising and regulating banking
institutions to ensure the safety and soundness of the nation's banking and
financial system and to protect the credit rights of consumers (Federal
Reserve Regulations)

3. Maintaining the stability of the financial
system and containing systemic risk that may arise in financial markets

4. Providing certain financial services to the
U.S. government, to the public, to financial institutions, and to foreign
official institutions, including playing a major role in operating the
nation's payments system.

In this section we will be focusing our attention on
the first of these function - the ability of the Fed to control the money
supply. For some additional information on the Fed and other central
banks, you might want to check out the following:

Banks have played a central role in the money supply process
and to understand the supply process we will need to examine the 'books' of banks.
By
studying these financial statements we will be able to see how the banks can affect the
money supply and how the FED can affect the banks. To understand how banks create money we need to begin with a
simple balance sheet for the ACM bank. The assets banks are allowed to own are
restricted by the Fed - a response to the devastating impact of the stock market crash of
1929 on the banking system. In our simple example we will assume the bank's
assets consist of cash (reserves), loans, and government securities. Banks will hold
government securities and loans because they earn interest - you pay interest on car
loans and the government pays interest on its loans which are the bonds (securities). Banks
will also hold cash as reserves which earns no interest so you would expect banks pursuing
a profit to make every effort to minimize their holdings of cash. In the example
below, the bank's assets total $5,500,000.

The banks' primary liabilities are the balances on the
checking and savings accounts held by their customers. In the example below, the ACM
bank's liabilities total $5,000,000 which gives it a net worth of $500,000. As we go
through our example you will note that despite changes in the assets and liabilities, the
two sides of the balance sheet will be equal.

You will also note there is a link between the two sides based on the Fed's regulation of the banks. Specifically, the Fed sets the required reserve rate for the banks
specifying the amount of cash a bank must keep on hand to back the demand
deposits (checking accounts). In this example we are assuming the Fed is requiring
the bank to hold 20 percent of the amount of its deposit accounts as cash (reserves). To
"support" the $5,000,000 in checking account balances, the bank will be required
to hold $1,000,000 as required reserves. Given this is all of the cash the
bank has, there are no excess reserves.

Stage 1: ACM's
Initial Balance Sheet

ACM's "Books:" Initial Situation

Assets

Liabilities

Securities

$500,000

Reserves

Checking deposit

$5,000,000

Actual

$1,000,000

Saving deposit

$0

Required

$1,000,000

Net Worth

$500,000

Excess

$0 *

Loans

$4,000,000

Total

$5,500,000

Total

$5,500,000

* If banks have inadequate reserves (excess reserves < 0) then they can borrow
money to satisfy the necessary reserve requirements. They can borrow from the Federal
Reserve at the discount window or from other banks in the federal funds market.

Stage 2: ACM's
books after a $100,000 infusion of cash

It is now time to see what happens when Mary walks into ACM with $100,00 in cash
(where they get the extra cash is another story for another time). The bank will take
Mary's $100,000 and add it to its assets, but it will send Mary away with an extra
$100,000 in her checking account. Because the checking deposits have risen by $100,000,
the bank will be required to hold 20 percent of this amount as additional reserves.
The $20,000 increase in required reserves will bring required reserves to $1,020,000 so the bank now has $80,000 in excess reserves - assets it will be making no money
on. This sets the stage for the next stage when the bank undertakes policies to rid itself
of the excess reserves. You can see double-entry accounting has resulted in an
increase of $100,000 on both sides of the balance sheet.

ACM's "Books:" After $100,000 Deposit

Assets

Liabilities

Securities

$500,000

Reserves

Checking deposits

$5,100,000

Actual

$1,100,000

Saving deposits

$0

Required

$1,020,000

Net Worth

$500,000

Excess

$80,000

Loans

$4,000,000

Total

$5,600,000

Total

$5,600,000

bank accepts $100,000 in cash (reserves rise by $100,000) and adds $100,000 to the
account of the depositor (checking deposits rise by $100,000)

The bank will now attempt to transform the $80,000 into income earning assets.
In this example we assume the bank loans out the $80,000 so the loan
balance increases by $80,000 and the level of reserves falls by an equal amount. The bank
is now left with $1,020,000 in cash, precisely what it is required to hold, so excess reserves
have been reduced to $0. But what has happened to the $80,000?
Someone has the cash and we can expect they will deposit it in a bank - bank KAB will
receive a deposit of $80,000 which is where we will pick up the story in Stage 4.

ACM's "Books:" After Eliminating Excess Reserves

Assets

Liabilities

Securities

$500,000

Reserves

Checking deposits

$5,100,000

Actual

$1,020,000

Saving deposits

$0

Required

$1,020,000

Net Worth

$500,000

Excess

$0

Loans

$4,080,000

Total

$5,600,000

Total

$5,600,000

bank lends out $80,000 of excess reserves in form of cash (reserves fall by $80,000
and loans rise by $80,000)

$80,000 will work its way back into the banking system as another infusion of cash -
this time an infusion of $80,000 into Bank KAB.

Stage 4: KAB's
books after deposit $80,000

We are now back where we started - with an infusion of $80,000 into a bank - a new
bank called KAB. The bank's assets rise to $80,000 in cash which is offset by an $80,000
entry in the checking account balance. You can expect this bank will follow the same
procedure to rid itself of excess reserves - it is required to hold 20 percent of the
$80,000 as cash so it has excess reserves of $64,000.

KAB's "Books:" After $80,000 Deposit

Assets

Liabilities

Securities

$0

Reserves

Checking deposits

$80,000

Actual

$80,000

Saving deposits

$0

Required

$16,000

Net Worth

$0

Excess

$64,000

Loans

$0

Total

$80,000

Total

$80,000

bank takes in $80,000 as cash and credits checking accounts for the $80,000

the bank must hold $16,000 as additional required reserves (.2*$80,000) which gives
it $64,000 of excess reserves

Stage 5: KAB's
books after elimination of excess reserves

The bank will now attempt to transform the $64,000 into income earning assets. In
this example we have assumed the bank loans out the $64,000 so the loan balance
increases by $64,000 and the level of reserves falls by an equal amount. The bank is now
left with $16,000 in cash which is precisely what it is required to hold so the level of
excess reserves has been reduced to $0. But what has happened to the $64,000? Someone has
the cash and we can expect they will deposit it in a bank - bank MRM will receive a
deposit of $64,000 which is where we will drop the story and move quickly to our
conclusion.

ACM's "Books:" After Eliminating Excess Reserves

Assets

Liabilities

Securities

$0

Reserves

Checking deposits

$80,000

Actual

$16,000

Saving deposits

$0

Required

$16,000

Net Worth

$0

Excess

$0

Loans

$64,000

Total

$80,000

Total

$80,000

bank takes excess reserves of $64,000 and loans out this cash (excess reserves and
actual reserves decline by $64,000 and loans increase by $64,000)

the $64,000 in cash eventually works its way back into banking system as additional
cash infusion

Conclusion: Money
creation in banking system

It's now time to retrace the flow of $s through the banking system. Below you will
find the changes we could expect in the balance sheets of the banking system's banks.
In bank ACM where the process began, the bank's loans increased by $80,000, its cash by
$20,000, and its checking account balances by $100,000. Bank KAB, meanwhile, will see its
Loans increase by $64,000, its required reserves increase by $16,000 and its checking
account balances by $80,000. The $64,000 loan made by KAB will be deposited into an
account at bank MRM where 20 percent ($12,800) will be kept as reserves against checking
balances of $64,000 and 80 percent ($51,200) will be loaned out which will find its way
into bank AJM.

Following the Money: A Scorecard

Bank ACM

Reserves

$20,000

Checking account

$100,000

Loans

$80,000

Bank KAB

Reserves

$16,000

Checking account

$80,000

Loans

$64,000

Bank MRM

Reserves

$12,800

Checking account

$64,000

Loans

$51,200

Bank AJM

Reserves

$10,240

Checking account

$51,200

Loans

$40,960

Bank LRG

Reserves

$8,192

Checking account

$40,960

Loans

$32,768

To see the cumulative effect, we can simple reorganize the table above and create a
Composite of the Banking System table to show the changes in reserves, deposits, and loans
in each of the banks. What we see is that the $100,000 cash deposit has been transformed
into bank reserves of $100,000, deposits of $500,000, and loans of $400,000. Because the
deposit balances are part of the money supply, we have seen a $100,000 increase in cash
has produced a $500,000 increase in the money supply

Composite of the Banking System

Reserves

Deposits

Loans

Bank ACM

$20,000

$100,000

$80,000

Bank KAB

$36,000

$80,000

$64,000

Bank MRM

$48,800

$64,000

$51,200

Bank AJM

$59,040

$51,200

$40,960

Bank LRG

$67,232

$40,960

$32,768

Bank FTS

$73,786

$32,768

$26,214

...

Total

$100,000

$500,000

$400,000

Because of the fractional reserve system, banks can multiply the high-powered money
that the Fed puts into the system. In this example there are no excess reserves and
the banks will take a $100,000 increase in high-powered money and transform it into a
$500,000 increase in demand deposits so the money multiplier would be 5. We are now
ready to put the pieces together - the Fed and the banks. It is time to look at how
the Fed can influence the money supply.

Fed's Control of the Money
Supply

The money supply contains coins and currency in the
hands of the public, controlled by FED, and deposits accounts controlled by the
interaction of the households and firms that use money and the banks that create
money. At this point we have discussed the structure of the Fed and the money
creation process in the banking system. It is now time to put the two together
to see how the Fed can alter the money supply.

The money supply (M1) can be increased if the coins
and currency in circulation increase or the checking account balances (demand
deposit) increase. There are four ways that this can happen.

required reserve rate is lowered:
The Fed can lower required reserve rate which raises the multiplier effect
of high powered money (cash). The cash stays in the banks and each dollar
can support more loans/demand deposits.
In our example, it the required reserves went from 20 percent to 10 percent,
bank ACM would only need to hold $10,000 in reserves for the initial
injection of $100,000. The other $90,000 would be loaned out so at
each stage in the multiplier chain, the banks would be loaning out more
funds and the eventual increase in the money supply would be larger.

discount interest rate decreases:
The Fed can lower the discount rate and lower the costs for banks holding
low excess reserves which will lower the excess reserve rate. If the
Fed lowers the discount rate, or sets a lower federal funds target, this can
be accomplished if the Fed injects funds into the system which will drive
down the price of those funds - interest rates. To see how it could
increase the level of cash in the system, we can turn to the next Fed tool -
open market operations.

publics' holding of cash changes:
The Fed can raise confidence in banking system which will lower public's
desire for holding cash. If you
look at the high-powered money the Fed can inject into the system, a dollar
in the hands of an individual is simply a dollar of money supply. A
dollar in reserves at the banks, however, can support some multiple
expansion of checking accounts. For example, when the required reserve
rate was 10 percent, the $100,000 cash injection the system ultimately
resulted in a $500,000 increase in checking account balances. Thus if
the Fed can move dollars from people's pockets to banks, this will increase
the money supply. In the Great Depression, one of the real problems
was people lost confidence in the banks and took their cash out of the
banks, a pattern that caused the money supply to decrease.
When people want cash, the reserves in the banks fall which creates a bigger
drop in demand deposits. The result is a net decrease in the money
supply. For this reason you would expect every Christmas season the
money supply would decrease as consumers want to hold more cash. To
offset this the Fed will need to get more cash into the system. The
same will happen as the Fed attempts to offset the public's hoarding of
money at the turn of the millennium.

open market purchases:
this is the Fed's primary tool of monetary policy. The Fed can buy or
sell government securities. Let's look at the situation when the Fed
wants to increase the money supply. The Fed will contact its broker
and announce it wants to buy $100,000 of government securities. To
make life easy we will assume the securities the Fed buys are sold by
Herschel Perot who deposits the cash in his bank - ACM National Bank.
The original balance sheet of the bank appears below.

ACM National Bank's Initial Balance
Sheet

Assets

Liabilities

Securities

$500,000

Reserves

Checking deposit

$5,000,000

Actual

$1,000,000

Saving deposit

$0

Required

$1,000,000

Net Worth

$500,000

Excess

$0 *

Loans

$4,000,000

Total

$5,500,000

Total

$5,500,000

After the Fed purchase of the bonds from Mr.
Perot and his deposit of the cash into his bank, ACM National Bank's balance
sheet is:

ACM National Bank's books after a
$100,000 infusion of cash

Assets

Liabilities

Securities

$500,000

Reserves

Checking deposits

$5,100,000

Actual

$1,100,000

Saving deposits

$0

Required

$1,020,000

Net Worth

$500,000

Excess

$80,000

Loans

$4,000,000

Total

$5,600,000

Total

$5,600,000

This should look very familiar. It is
in fact the first two stages of the money creation process that we examined
earlier and you will recall the results. The increase of $100,000 cash
into the system will result in an increase in the money supply of
$500,000. Now you know why the Fed uses this policy to manage the money
supply. If the Fed wants to increase the money supply it will buy
government securities, while if it wants to decrease the money supply it
will sell government securities.

Although all of the above are policy tools of the
FED, Open Market Operations tend to be the favored tool. Their popularity stems
from the fact that the decisions are reversible, flexible, and timely. The
Fed's tools are summarized in Diagram 4 below.

Diagram 4Fed Policy Tools

Tools

Goal:
Increase Money Supply

Goal:
Decrease Money Supply

Discount
rate

lower

raise

Required
reserve rate

lower

raise

Open
market operations

but
securities

sell
securities

If the FED increases the money supply, then this
would show up as an outward shift in the money supply curve in the money market.
The outward shift could be accomplished by a reduction in the discount rate,
open market purchases, or lower required reserve rates.

Increase in Money Supply

It's now time to turn our attention to what
impact the change in the money supply